Tuesday, April 01, 2008

Interest on Interest: an Intergenerational Fable

Cross posted at AB"I'm not sure that "interest on interest" means very much if the government would be borrowing the same amount from somewhere else."

The following fable shows the potential problem of just letting Interest compound if we get outcomes close to Low Cost.___________________ Follow the cash flow and its magnitudes over time. Who paid extra when, who pays less or draws out more later. Let me try a story.

Generation A pays into Social Security on a PayGo basis but also pays in extra to build up a cushion.Generation B pays into Social Security on a PayGo basis but neither pays in extra or draws on the cushion which meanwhile grows through compound interest.Generation C pays into Social Security on a mostly PayGo basis but on retirement draws down on the interest on the accumulated cushion in moderate way but not enough to keep it growing pretty fast.Generation D pays into Social Security on a still mostly PayGo way but on retirement draws down on the cushion all of the interest being accrued on a Trust Fund now with a seven year reserve.Generation E pays into Social Security on a still mostly PayGo way but is stuck with a huge annual interest bill to pay benefits by Generation D and remaining Generation C's. A bill that doesn't go away.

Which sets up the conflict. Generation A whether they drew any direct benefit from the cushion still knew it was there if needed by Generation B.

Generation B is held harmless here. Aware and grateful for the cushion but knowing their own contributions over a lifetime balanced their average return.

Generation C starts getting a free ride. They did not pay in their full fare, instead they are veritable Trust Fund Babies thanks to that partial interest drawdown.

Generation D gets a pretty good ride. Drawing the full value of interest on the Trust Fund gives them a pretty nice standard of living, and all originally paid for by great granddad A. Thanks G G A!

Generation E gets kind of a bumpy ride. Now that all the interest is being paid out the Trust Fund balance is frozen and so starts getting eaten away by inflation. Meanwhile they are paying in still mostly PayGo but are also stuck with a large and growing bill for interest all of which goes for the benefit of Generation D and remaining C's who when you think about it never paid their full fare ('almost PayGo' not being 'PayGo') to say nothing of not having had to kick in the extra to start with. Moreover most of the balance in the Trust Fund is just interest on interest accumulated during Generation B and C's lifetime. Meanwhile I got to find some way to pay college for Generation F!!!

Makes for a testy Thanksgiving when Grandpa and Grandma D fly in from their winter place in Arizona to find Son E working two jobs to try to get something, anything in the college fund for Daughter F while still having to pay $600 billion a year in interest on money mostly contributed by Great-Great Grandpa A. But whose actual cash was borrowed and spent on weapons systems now only seen in museums.

E is in a trap here. The Trust Fund is there, it has tens of trillions in securities, it has more years of reserves than it really needs. But the only way to actually get it to shrink in size is to cut income flowing to it. Which means a nice little FICA tax cut for those earning below the median. But E makes 3 x the cap, the tax cut doesn't mean much to him. Moreover paying down the principal in the Trust Fund to get the TF ratio down to a reasonable level and with it the annual interest accrual means paying an even higher level of income tax than before! And F still needs to go to college!!

Nice recipe for intergenerational warfare there. But it gets worse. Lets say Generation D is still not drawing down the total interest and the Trust Fund has ballooned to the point where annual interest would pay 110% of cost. E can never get ahead of the game at all. FICA could go to zero and he is still stuck with the bill. While all those people making wages at a level that doesn't trigger substantial income tax get a nice tax free 6.2% boost to put in their F's college fund and a paid retirement-'Thank you Mr. Man and of course Great-Great-Great Grandpa A!!!'

Mr. Man, aka E is not going to be happy here. He ends up with an income tax funded retirement system whose benefits flow disproportionately to lower income workers. 'Why it is nothing more than god damn welfare, and I don't give a crap that my Boomer Great Great Granddad A paid in extra all his working life. He didn't see a penny of that extra money back! And neither did Great Grandpa B, that old coot paid his way. Heck Grandpa Charlie hardly tapped into the pot and at least he remembers G G Granddad A. That guy is just an old hologram to me. Meanwhile Pop's got his place in Phoenix and every store clerk in the country is getting both their kid's college fund and their retirement paid by ME!!'

Mix in a little class warfare with the intergenerational piece and it makes for an ugly picture. Hopefully Marek won't get ahold of this story, the whole idea would give him a stroke.

It is not that Pop D or Cashier E did anything wrong here, that Pop paid in a lot less then he would have had this truly been PayGo from the start, that Cashier E is the beneficiary of monetary sacrifices of earlier generation of workers, none of them are to blame. But how do you explain that to E? or the Congressman to whom he is a big supporter?

The danger of interest on interest is that over time it converts Social Security from a worker funded insurance plan to a Welfare plan paid largely by the middle and upper classes, that is assuming the upper classes still pay any taxes at all by that point. What is more you can't get out of the trap by cutting benefits, that actually just makes the paper problem worse.